Talk About Share Market: Beware of share buybacks

Wednesday, September 8, 2010

Beware of share buybacks

UNDER normal circumstances, investors should get excited when companies buy back their own shares. In theory, this action implies the management views the best available investment opportunity for the utilisation of excess cash is to invest in its own company rather than buy into some other companies.

This is because when a company buys back its own shares, it will reduce the firm’s outstanding shares and enhance the company’s earnings per share (EPS).

Due to information asymmetry, the management is in the best position to determine that the company is being undervalued at the current price and, thus, it is to the best interest of the shareholders to buy back the company’s shares.

Hence, in general, we can conclude share buybacks usually convey a positive signal that implies the stock of a company is underpriced.

However, lately in Malaysia there was one listed company, Company K – we prefer to call it Company K than to reveal its real name – which showed unusual buying-back activities over an extended period up to May 17, 2010.

Here is an analysis of the Company K’s stock-price movement over this period. The price chart shows Company K had been hovering at around 80 to 90 sen until May 25, 2010. In fact, the company’s stock was being traded above 80 sen despite the recent financial crisis.

During the 2008-2009 market crashes, while the majority of companies were facing drops of 50% or more in their prices, Company K’s share price remained stable at above 80 sen.

Based on our observation of stock exchange filings, the stability of this company’s share price at around 80–85 sen appeared to be supported by its share buyback activities.

The company stopped buying its own shares since May 17. The last tranche of its share repurchase was on May 17 and the total number of shares bought were 36,000. As a result, since May 25, the stock prices started to plunge.

The main reasons for the sharp drop were because Company K defaulted on loans repayments and a few of the company’s key owners had left the company as well as the country.

As mentioned earlier, finance text books say when companies buy back their own shares, it implies the companies are undervalued.

However, in this case, Company K reported on June 7 RM146.5mil of losses for its fiscal fourth quarter ended March 31, 2010. Table 1 shows the company continued to buy back its own shares during the fourth quarter of FY10 and first quarter of FY11, even though the company was incurring huge losses during the periods. This seem to be against what we have learned from financial theory.

Investors may be wondering whether they are able to sell before the sharp plunge in share prices. Based on our observation, the company only announced the default in loans repayments on May 31, 2010 and the share prices immediately tumbled to a low of 10 sen.

By the time the company announced its fourth-quarter results on June 7, its share price remained low at 14.5 sen.

An interesting point to note from Table 1 is that coincidentally, Company K’s key owner, Mr JH, sold most of his holdings by the time the results were announced. He sold 39.2 million shares (53.4 million minus 14.2 million) from April 7 to June 7, 2010.

At the moment, due to the delay in submitting audited financial statements for the period ended March 31, 2010, shares in the company have been suspended from trading at 6.5 sen. The company is currently facing a winding-up petition and the appointment of provisional liquidators.

In short, share buybacks do not imply companies are undervalued. Investors need to be careful as some companies may use these activities to support their share prices.